Sequestration, Politics—and the Economy

Irwin M. Stelzer

February 2, 2013 12:00 AM

It took only a tiny drop of .01 percent in fourth quarter GDP to produce another battle in the ideological war that is going on in Washington. Republicans blame it on the president’s spending and deficits, the president and his team on the congressional Republicans they call a “major headwind” and on Fox News for opposing Barack Obama’s plans for more spending and higher taxes. The president says that there is no spending problem and “we don’t have to worry about the debt short term,” Republicans that spending is the problem.

Which brings us to the now famous sequester. It is the last weapon left to Republican spending cutters who thought discretion the better part of valor in the fiscal cliff fight and allowed taxes and tax rates to rise, and have agreed to raise the debt ceiling for the next several months without obtaining significant spending cuts as a quid pro quo. Unless a deal is reached to cut the deficit by $1.2 trillion over the next ten years, spending cuts will be triggered, to fall equally on defense and on some domestic programs. The theory was that these cuts would be repugnant to Republicans who fear that $600 billion of defense cuts would “devastate” the military and “create a substantial risk of not meeting our defense needs,” according to Leon Panetta, Obama’s departing defense secretary. And it would be unappealing to Democrats because their favored social programs would share the pain with the military. This mutual distaste would force the parties to agree to replace the sequester meat axe with a scalpel.

No such luck. The president insists that any deal include more tax increases on the “wealthy,” while the Republicans are adamant that the $600 billion increase he wrung from them during the fiscal cliff negotiations is all the new taxes he will ever get. Add that Republicans believe that defense secretary nominee Chuck Hagel has been told to cut back on the military. Since they can’t save the defense budget, Republicans figure they might as well use the sequester to get the cuts in domestic programs that the president has said he would not countenance if he had the power to block them. Which is why it is now considered likely that the sequester will be allowed to take effect on March 1.

Its effects are already being felt. The Pentagon, benefitting from the troop drawdowns in Iraq and Afghanistan, and knowing the bean counters are sharpening their pencils, cut spending in the last quarter by 22 percent, the largest such cut in 50 years. Along with a decline in inventories, that reduction in government spending accounted for most of the 0.1 percent fourth-quarter GDP decline. Pentagon suppliers began cutting staff last year, most visibly in the headquarters and research facilities surrounding the capital, their wailings and those of their workers and lobbyists clearly audible in the halls of Congress. As is their prediction that the sequester will add two million to the 12 million workers already on the unemployment rolls and produce a second consecutive quarter of negative growth, the standard definition of “recession.”

Meanwhile, with 75 percent of the 200 companies that have so far reported earnings beating analysts’ forecasts, and the Fed keeping interest rates close to zero, investors drove share price up a rousing 5 percent last month. They were undeterred by the decline of 0.1 percent in the fourth quarter because that aggregate figure obscured the healthy growth of the core drivers of the economy.

Businesses stepped up spending on plant, equipment and software at an annual rate of 8.4 percent. Consumers, who continue to trade in old vehicles, many with 150,000-200,000 miles on the odometer, for sleeker, electronics-laden, fuel-efficient ones, upped spending at a 2.2 percent rate (and in January drove sales of both GM and Chrysler up by 16 percent). Add the 15.3 percent growth in residential investment as the housing sector continues its recovery: home builders are rushing to meet the demand that is reflected in shortages of homes for sale and rising prices (up 5.5 percent in the past year), and which spurs sales of everything from furniture and carpets to power tools. All in all, the growth drivers added 2.7 percent to fourth quarter 2012 growth.

Throw in three other factors that minimize the importance of the 0.1 percent fourth-quarter decline. The reduction in government spending in late 2012 is not altogether a bad thing: if sustained, it might bring the deficit down. Second, the drop in inventories means more stuff moved off the shelves than was added to stocks, setting the stage for re-stocking in the next quarter. Finally, the Federal Reserve Board’s monetary policy committee notes that “weather-related disruptions and other transitory factors” added to the downward tug in the first quarter. So there is little reason to treat the 0.1 percent first-quarter downtick as a harbinger of hard times to come, and more reason to give weight to the growth in the consumer, business, and housing sectors, not to mention the demographic, energy, and insourcing trends detailed by Sharmin Mossavar-Rahmani of Goldman Sachs’s investment strategy group in “Over the Horizon.”

Still, it would be prudent to keep the champagne on ice, unopened.

· The 157,000 jobs created last month in an improving labor market nevertheless were too few to prevent a modest uptick in the unemployment rate from 7.8 percent to 7.9 percent, or to provide work for the more than 12 million unemployed workers.

· The 2.6 percent gain in personal income in December was inflated by bringing forward into 2012 dividends originally scheduled to be paid in 2013, in order to beat the dividend-tax increase.

· Sequester cuts in spending might knock some 0.7 percent off of GDP growth this year.

Then there are things we don’t yet know:

· The impact of the January 1 increase in payroll taxes: the average family has been hit with a $20-per-week cut in take-home pay.

· Whether “the wealthy,” faced with increases in tax rates on their incomes and capital gains, an Obamacare tax on their investment income, and whatever other bad news the Obama administration has in store for them, will rein in spending.

· Whether small businesses faced with substantial Obamacare penalties if they have more than 50 workers will continue to hold off on hiring and investment.

Add to these known unknowns the unknown unknowns, political and economic, and it would be foolish to claim a clear crystal ball. Still, this economist can’t help feeling that the U.S. economy will grow at a faster rate than the 1.5 percent consensus forecast. In part this is mere intuition, based on a feel for what I see in the malls, and hear from real estate developers and people whose lives are not Washington-centric. In part, too, it is based on early data for this first month of the new year. Auto sales by both GM and Chrysler jumped 16 percent in January. The Institute of Supply Management (ISM) manufacturing index rose last month, with new orders, production and employment all showing significant increases. The University of Michigan preliminary consumer sentiment index for January has been revised upward, reflecting an improvement in consumers’ expectations about the future. Private construction expenditures seem on track to continue recent increases. Builders are complaining about a shortage of skilled construction labor, as are oil and gas exploration companies. The city of Detroit is making a comeback of sorts based on higher payrolls in the auto industry and profit-sharing bonuses the auto companies are paying out to their workers. Straws in the wind only, but worth noting.